For those who need a wonky introduction to Bitcoin's technological base, go here.
For a normal explanation so you know some background go here.
I'm writing this diary to get, on the record, my economics/finance perspective on the current Bitcoin market.
I have no current vested interest in Bitcoins or any Bitcoin-related assets.
As I see it, Bitcoin's value components are as follows:
1) Speculation (I'm buying a Bitcoin with $€ so I can sell it later for more $€)
2) Black market industrial trade needs. (I'm buying a Bitcoin to buy Drugs/ChildPorn/etc.)
3) General storage of assets in a system where you see value in anonymous transactions due to trust issues (I'm buying a Bitcoin because I'm paranoid/think it's neat).
Not exactly the most foundational reasons to invest in something...
I call Bitcoins "the digital tulips".
The term stems from the 17th century Tulip Futures market in Holland, which became so overbought that bundles of tulips were being sold for 20x their value from a mere year before.
The price reached such an absurd level that the market crashed so quickly it wiped out the fortunes of thousands of Dutch speculators.
Click below and I'll go into a quick discussion about the current Bitcoin price action and why I think this a bubble due to pop this year.
Normally when you take your hard-earned dollars and INVEST in something, say bonds or stocks, you're purchasing a claim on cash flows (for bonds and money market and other debt instruments), or a claim on earnings (for stocks). So there's a simple mathematical base for evaluating what price to pay for the asset.
For assets like real estate it's similar -- you can look at it as an investment with rental cash flows, or as a physical house made up of certain materials that cost money and has a utility for living in and that may go up in value later. Still, there's a base model for how to value property.
And then you have metals -- the preferred assets of Austrian economics enthusiasts and skeptics of fiat currency worldwide. These are things that do have an industrial use, and thus there's demand for actual goods, but they also have a use for jewelry and value for storage strength. But in reality they cost money to hold. So the value components for metal include industrial, jewellery, and speculation/value storage with historical significance.
Then there's Bitcoin. You can buy it because it's a cool anonymous digital cryptocurrency, but how much is that really worth to you? Or you can buy it because you wanna buy a couple of pills from Silk Road, but then you're really only caring about the comparable dollar value to make sure you're not overpaying for your dope. Or maybe you're a big-time drug dealer or money launderer and you don't mind taking a hit on the value, so you're willing to bid up the price in order to hold Bitcoins. Here's the current price action:
So you can see the price basically started out at $0 in 2010 and has shot up to $100 as of today. And the number of Bitcoins in circulation has gone up from the start of a few million to about 11 million now. That means the value of the millions of Bitcoins went from 0 in 2010 to now worth over $1 billion dollars in March 2013 (11 million x $100/BTC). All because of a value from anonymity, novelty, or to buy some drugs of Silk Road or make some other shady transaction? It really doesn't add up if you use basic reasoning. In terms of black market trade, you're only going to be comparing the dollar value you use to purchase the Bitcoins for purchasing the goods in order to compare the real value you're getting from it. As in, "Okay, so this bag of weed is 1 bitcoin, let me see how much that is in dollars" -- so it's still just a reference point that will be used to compare "how much is this in dollars, and how much can I get of some other real good with that number of dollars" -- this is the mental process we go through subconsciously or consciously to figure out if something is worth the price.
The point is, there's very limited actual value to be seen in buying Bitcoins. A look at the price action makes speculation especially attractive (as the price recently has gone up exponentially), but then we're in bubble-analysis mode. And when you're in that mode, the question is when, not if the market will crash.
Five Key Points
Here's an outline of why I think Bitcoin will crash in price, sometime this year (2013), likely very soon:
1) CLASSIC BUBBLE
- The demand is not sustainable at current rates as there is no measurable sensibility to present price levels. Inflation of the dollar's purchasing power is not a reason we can see in the data. Increased use in meaningful industrial trade is not occuring, it's primarily still a black market trade currency. So whereas other financial assets or real assets have some measurable quantifiable model for the value, Bitcoin seems to be a pure speculative dream. The only indication is that there's bubble mania. And bubbles always pop.
At first look, it appears as if we're nearing the "delusion/greed" stage. The big players who bought up the market in the beginning and have been supporting it will surely be looking for an exit soon, and the weight will be too much to bare. This figure is a basic outline, but it really is following the general price action of Bitcoin conceptually.
2) NO ORDERLY MARKET TO BALANCE LONG/SHORT INTEREST
- There's no futures or short-selling to help offset the mania with some short-end speculators to help reduce the upward price psychology. Even tulip bulbs were traded on the futures market which allowed for short exposure, which wasn't enough to hold back the bubble, but this isn't helping bitcoin's case.
3) PRESSURE FROM AUTHORITIES
- There's discussion in the mainstream by the ECB, FBI, and other authorities about the currency -- a higher profile leads to more scrutiny and perhaps more negativity to lead people to "get out while they can" and the currency may drop from there.
Additionally, there's been a number of "bitcoin heists" and "hacks". These incidents, if they get more high profile and even bigger (as they surely will with a higher dollar price of Bitcoins) will only dissuade potential buyers, hurting demand.
4) PRESSURE FROM COMPETITORS
- Other payment processors (Mastercard, visa) not happy with this, will use political power to shut it down. There is a reluctance for real industrial trade to adopt Bitcoins because of the dubious nature of the cryptocurrency. Many reject it just because it "seems" illegal.
5) LACK OF CASH FLOW/TRADE VALUE
- You get nothing for holding a Bitcoin except the possibility that its value in dollars will go up, or the ability to purchase goods offered for Bitcoins (usually black market goods). This alone shows that the price action we're observing in the Bitcoin market is following no real fundamental path.
In the summer of 2011, a $9 million Bitcoin selloff (not even 5% of the outstanding Bitcoins at the time) led to a total crash in the market. With this in mind, it's tough to believe that the market at current price levels would be able to manage a considerable liquidation of bitcoins, and any significant drop would surely lead to fear-driven sell-offs to avoid getting out too late.
There's already been a brave "first mover" into the Bitcoin market back in 2011, which bid the price of Bitcoins up significantly from a few cents to dollars-range. It's mindblowing why people would begin to bid up the value from essentially $0 to $30 back in mid-2011. It's even more puzzling why, 2 years since then, the price has tanked back to around $10 and now in 2013 surged to $100 per bitcoin. There's nothing but speculation driving this value, or perhaps something more nefarious.
Now that the taboo has been broken, there's more free-flowing exchanges of Bitcoins at a price that is no longer insignificant. The question now becomes, will the value hold once you buy Bitcoins to purchase real goods? Or to buy and hold? The volatility seems extreme enough to keep any risk-averse consumers from dabbling in it, that's for certain.
In the end, the value is not justified and holders of Bitcoins will desire to get out eventually to use dollars for non-black-market goods. Once that sell spiral begins, it won't stop until the correction is significant and deep enough to have people come in to support a lower level with purchases.
The popularization of the Bitcoin market since 2011 has led to a creation of $1 billion in market value for a cryptocurrency whose only observable purpose is to provide anonymous transactions for the black market trade and to support "grey" organizations like Wikileaks and other hackers. This is the main fact that one should be thinking about when valuating this market. Has this market really added, legitimately, $1 billion in value?
Hoarding of the coins could be a temporary relief of a selloff, but the sell pressure will build up and eventually those with a lot of unrealized profits will sell, because in the end you need central bank currency to engage in real market.
Like the Dutch Tulips, this bubble could continue for a long time. I am calling it for this year, and it will crash hard. But I think there's more to this Bitcoin story than just a cute alternative currency, there must be major criminal money laundering activity going on here. The only people willing to spend the kind of money that would prop up the market are individuals willing to risk losing money because the money is dirty to begin with.
It's worth noting the WikiLeaks connection. WikiLeaks has been a major proponent of Bitcoin use and has had trouble with traditional payment processors in the past years. They hold a significant number of Bitcoins, and it would not be uncharacteristic of Julian Assange (who has attracted negative attention from a lot of powerful figures) to be creating this bubble and media hype to support a slow exit from Bitcoin and amassing great wealth participating in major moneylaundering and criminal activity. I do not have documented evidence of this, but I would like to put this here on the record. Other theories include childporn/drug cartel players in the market and crazy Austrian economics investors).
The choice is yours. If you think the bubble has more months or years to it, go ahead and buy. But remember, you're not buying an asset that is providing any cash flows or any industrial base at all. Instead you're buying into a criminal conspiracy which is likely to collapse any time now. What may seem like a cute novel idea is in all likelihood a major scam which people are setting up to milk the public out of money when they want to actually get out.
If the crash doesn't happen in the next month, or by this summer, or even by 2013, then it will surely happen within the next couple years (as some others have speculated for example at Naked Capitalism). But I don't see the current price levels being sustained any longer than the next month.